Ch24 The economy at full employment: The
Classical Model
I.
The Classical Model: A Preview
The Classical Model is introduced.
1.
There are two distinct categories of variables that describe macroeconomic performance:
a)
Real variables: real GDP, employment and unemployment, the real wage rate,
consumption, saving, investment, and the real interest rate.
b) Nominal variables: the price level (CPI or GDP deflator), the inflation rate,
nominal GDP, the nominal wage rate, and the nominal interest rate.
2.
The separation of macroeconomic performance into a real part and a nominal part is the
basis of the classical dichotomy.
3.
The classical dichotomy states: “At full employment, the forces that determine real
variables are independent of those that determine nominal variables.”
4.
The classical model is a model of an economy that determines the real variables at
full employment.
5.
Most economists believe that the economy fluctuates around full employment, but that
the classical model provides powerful insights into the level of full employment and
potential GDP around which the
economy fluctuates.
II. Real GDP and Employment
A. Production Possibilities
1.
The production possibilities
frontier (PPF) is the boundary
between those combinations of
goods and services that can be
produced and those that cannot.
2.
Figure 8.1(a) illustrates a
production possibilities frontier
between leisure time and real
GDP.
3.
The more leisure time forgone, the
greater is the quantity of labor
employed and the greater is the
real GDP.
4.
The PPF showing the relationship
between leisure time and real GDP
is bowed-out, which indicates an
increasing opportunity cost: As
real GDP increases, each
additional unit of real GDP costs
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an increasing amount of forgone leisure.
5.
Opportunity cost is increasing because the most productive labor is used first and as
more labor is used, the labor used becomes increasingly less productive.
B. The Production Function
1.
The production function is the relationship between real GDP and the quantity of
labor employed when all other influences on production remain the same.
2.
One more hour of labor employed means one less hour of leisure, therefore the
production function is the mirror image of the leisure time-real GDP PPF.
3.
Figure 8.1(b) illustrates the production function that corresponds to the PPF shown in
Figure 8.1(a).
III. The Labor Market and Potential GDP
A. The Demand for Labor
1.
The quantity of labor demanded is the labor hours hired by all the firms in the
economy.
THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL
2.
The demand for labor, Figure 8.2,
is the relationship between the
quantity of labor demanded and the
real wage rate when all other
influences on firms’ hiring plans
remain the same.
3.
The real wage rate is the quantity
of good and services that an hour of
labor earns.
a)
169
The money wage rate is the
number of dollars an hour of
labor earns.
b) The average real wage rate is the
average money wage rate
divided by the price level
multiplied by 100.
c)
4.
It is the real wage rate, not the
money wage rate, that
determines the quantity of labor
demanded.
The demand for labor depends on the
marginal product of labor, which
is the additional real GDP produced by an additional hour of labor when all other
influences on production remain the same.
a)
The marginal product of labor is calculated as the change in real GDP divided by the
change in the quantity of labor employed.
b) The marginal product of labor diminishes as the quantity of labor employed
increases, other things remaining the same. Diminishing marginal product occurs
because all the labor employed works with the same fixed capital and technology,
and is an example of the law of diminishing returns.
c)
The diminishing marginal product of labor limits the demand for labor.
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5.
The demand for labor is the
marginal product of labor. Figure
8.3 shows the production function,
PF, in part (a). The production
function determines the marginal
product of labor. And the marginal
product of labor curve is the
demand for labor curve in part (b).
a)
Firms hire more labor as long
as the marginal product of
labor exceeds the real wage
rate.
b) Eventually, with the
diminishing marginal product
of labor, the extra output from
an extra hour of labor is
exactly what the extra hour of
labor costs, which is the real
wage rate. At this point, the
profit-maximizing firm hires
no more labor.
c)
When the marginal product of
labor changes, the demand for
labor changes. If the marginal
product of labor increases, the
demand for labor shifts
rightward.
B. The Supply of Labor
1.
The quantity of labor supplied
is the number of labor hours that
all the households in the economy
plan to work at a given real wage
rate.
2.
The supply of labor is the
relationship between the quantity
of labor supplied and the real wage rate when all other influences on work plans remain
the same.
3.
The quantity of labor supplied increases as the real wage rate increases for two reasons:
a)
Hours per person increase because the higher the real wage rate, the higher the
opportunity cost of not working. There is an opposing income effect. The higher real
wage rates increase household income, which increases the demand for leisure. An
increase in the demand for leisure is the same thing as a decrease in the quantity of
labor supplied. The opportunity cost effect is usually greater than the income effect
over the relevant range for most U.S. workers, so a rise in the real wage rate brings
an increase in the quantity of labor supplied.
b) Labor force participation increases because higher real wage rates induce some
people who choose not to work at lower real wage rates to enter the labor force.
THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL
4.
The labor supply response to an
increase in the real wage rate is
positive but small. A large
percentage increase in the real
wage rate brings a small
percentage increase in the
quantity of labor supplied. Figure
8.4 illustrates a labor supply
curve.
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C. Labor Market Equilibrium and Potential GDP
1.
Labor market equilibrium occurs when
the real wage rate is such that the
quantity of labor demanded is equal to
the quantity of labor supplied. Figure
8.5(a) illustrates labor market
equilibrium.
2.
Labor market equilibrium is fullemployment equilibrium.
3.
The level of real GDP at full
employment is potential GDP. Note
that in Figure 8.5(a), labor market
equilibrium occurs at 200 billion labor
hours. Referring back to the production
function in Figure 8.1, repeated as
Figure 8.5(b), 200 billion labor hours
means that potential GDP is $10 trillion.
IV. Unemployment at Full Employment
A. Unemployment always is present.
1.
The unemployment rate at full
employment is called the natural rate of
unemployment.
2.
The natural unemployment rate is always
positive; that is, there is always some
unemployment because of job search and
job rationing.
B. Job Search
1.
Job search is the activity of workers
looking for an acceptable vacant job.
2.
All unemployed workers—frictionally,
structurally, and cyclically unemployed
— search for new jobs, and while they
search many are unemployed. Job search
unemployment, and how it relates to
THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL
173
the natural unemployment rate, is
illustrated in Figure 8.6.
3.
Job search can be affected by:
a)
Demographic change. As
more young workers entered
the labor force in the 1970s,
the amount of frictional
unemployment increased as
they searched for jobs.
Frictional unemployment
might have fallen in the 1980s
as those workers aged. Twoearner households might
increase search, because one
member can afford to search
longer if the other still has
income.
b) Unemployment compensation. The more generous unemployment compensation
payments become, the lower the opportunity cost of unemployment, so the longer
workers search for better employment rather than any job. More workers are
covered now by unemployment insurance than before, and the payments are
relatively more generous.
c)
Structural change. An increase in the pace of technological change that reallocates
jobs between industries or regions increases the amount of search.
C. Job Rationing
1.
Job rationing is the practice of paying a real wage rate above the equilibrium level and
then rationing jobs by some method.
2.
Job rationing can occur for two reasons:
a)
A firm pays an efficiency wage, which is a real wage rate set above the fullemployment equilibrium wage rate that balances the costs of benefits of this higher
wage rate to maximize the firm’s profit. The higher wage rate attracts the most
productive workers and then gives them the incentive to be productive so they do
not lose their high-paying jobs.
b) A minimum wage is the lowest wage rate at which a firm may legally hire labor.
If the minimum wage is set above the equilibrium wage rate, job rationing occurs
D. Job Rationing and Unemployment
1.
If the real wage rate is above the equilibrium wage, regardless of the reason, there is a
surplus of labor that adds to unemployment and increases the natural unemployment rate.
2.
Most economists agree that efficiency wages and minimum wages increase the natural
unemployment rate.
a)
Card and Krueger have challenged this view and argue that an increase in the
minimum wage works like an efficiency wage, making workers more productive and
less likely to quit.
b) Hamermesh argues that firms anticipate increases in the minimum wage and cut
employment before they occur. Therefore, looking at the effects of minimum wage
changes after the change occurs misses the effects.
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c)
Welch and Murphy say regional differences in economic growth, not changes in the
minimum wage, explain the Card and Krueger theory.
V. Investment, Saving, and the Interest Rate
A. Potential GDP depends on the quantity of productive resources, including capital.
1.
2.
3.
The capital stock is the total amount of plant, equipment, buildings, and inventories,
physical capital.
Gross investment is the purchase of new capital. Depreciation is the wearing out and
scrapping of the capital stock. Net investment equals gross investment minus
depreciation; net investment is the addition to the capital stock. Investment is financed
by saving, which equals income minus consumption.
The return on capital is the real interest rate , which is equal to the nominal interest
rate adjusted for inflation. The real interest rate is approximately equal to the nominal
interest rate minus the inflation rate.
B. Investment Decisions
Business investment decisions are influenced by:
1. The expected profit rate. The expected profit rate is relatively high during expansions
and relatively low during recessions. Increases in technology can increase the expected
profit rate. Taxes affect the expected profit rate because firms are concerned about the
after-tax profit rate.
2.
The real interest rate. The real
interest rate is the opportunity cost
of investment. An increase in the
real interest rate decreases the
number of investment projects that
are profitable.
C. Investment Demand
1.
Investment demand is the
relationship between investment
and the real interest rate, other
things remaining the same.
2.
The investment demand curve,
illustrated in Figure 8.7, plots the
relationship between investment
demand and the real interest rate.
a)
The investment demand curve
slopes downward. A rise in
the real interest rate (say from
4 percent to 6 percent)
decreases the quantity of
planned investment demanded
(from $1.2 trillion at A to
$1.0 trillion at B) along
investment demand curve ID
in Figure 8.7.
b) If the expected profit rate increases, the investment demand curve shifts rightward.
THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL
175
D. Saving Decisions
1.
Households divide their disposable income between consumption expenditure and
saving.
2.
Saving is affected by the real interest rate, disposable income, wealth, and expected
future income.
3.
The higher the real interest rate,
the greater is a household’s
opportunity cost of consumption
and so the larger is the amount of
saving.
4.
The larger disposable income, the
greater is a household’s saving.
5.
The greater is a household’s
wealth, the greater is its
consumption and the less is its
saving.
6.
The higher a household’s
expected future income, the
greater is its current consumption
and the lower is its current saving.
E. Saving Supply
1.
Saving supply is the
relationship between saving and
the real interest rate, other things
remaining the same.
2.
Figure 8.8 shows a saving supply
curve, which slopes upward
because a rise in the real interest
rate increases saving.
F. Equilibrium in the Capital Market
1.
In the U.S. economy, there are many interrelated capital markets. Because funds can flow
from one market to another, we can think about the capital market as a whole.
2.
The real interest rate is determined by investment demand and saving supply.
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3.
In Figure 8.9, ID is the investment
demand curve, SS is the supply of
saving curve, and the equilibrium
real interest rate is 6 percent. At
the equilibrium real interest rate,
there is neither a shortage nor
surplus of saving.
VI. The Dynamic Classical Model
A. The Classical Model also has
implications for how the economy
changes over time.
B. Changes in Productivity
1.
Labor productivity is real GDP
per hour of labor.
2.
Three factors influence labor
productivity.
a)
Physical capital: An increase
in capital increases labor
productivity.
b) Human capital: Human
capital is the knowledge and
skill that people have
obtained from education and
on-the-job-training. An increase in human capital increases labor productivity.
c)
3.
Technology: An increase in technology increases labor productivity.
When labor productivity increases, the production function shifts upward and potential
GDP increases.
THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL
C. An Increase in Population
1.
Figure 8.11 (mislabeled as Figure
8.12) illustrates the effects from an
increase in population.
2.
An increase in population increases
the supply of labor and the supply
of labor curve shifts rightward. The
equilibrium real wage rate falls and
the equilibrium quantity of
employment increases.
3.
The increase in employment leads
to a movement up along the
production function so that
potential GDP increases. However,
diminishing returns means that
potential GDP per hour of work
decreases.
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D. An Increase in Labor Productivity
1.
Figure 8.12 (mislabeled as Figure
8.11) illustrates the effects from an
increase in labor productivity.
2.
An increase in labor productivity
can be the result of an increase in
physical capital, an increase in
human capital, or an advance in
technology. In all cases, the
production function shifts upward
and the demand for labor increases
so that the demand for labor curve
shifts rightward. The increase in the
demand for labor raises the
equilibrium real wage rate and
increases the equilibrium quantity
of employment.
3.
The increase in employment leads
to a movement up along the
production function. In addition, the
increase in labor productivity
shifted the production function
upward. Both effects increase
potential GDP. The upward shift of
the production function means that
potential GDP per hour of work
increases.
THE ECONOMY AT FULL EMPLOYMENT: THE CLASSICAL MODEL
E. Population and Productivity in the United States
1.
In the United States, over the past
two decades, both the population
and labor productivity have
increased.
2.
Figure 8.13 illustrates these effects.
3.
The increase in the demand for
labor exceeded the increase in the
supply of labor so that the real
wage rate rose. Employment
increased as a result of both the
increase in the demand for labor
and the increase in the supply of
labor.
4.
The increase in productivity shifted
the production function upward.
That, combined with the increase
in employment, increased potential
GDP.
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